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Hi,
I don’t quite understand how to identify relevant costs when materials are held in inventory. Here’s an example:
Glory Ltd is a supplier of cotton for wonder textiles. Glory sold 5000 kg of cotton in March 2010 at a price of £4 per kg.In May 2010, wonder received a contract for ready made shirts, which would require 8000 kg of cotton which is used regularly in normal production.
The cotton purchased from Glory in the last financial year has not been used in the production process till date and is included in the amount of opening inventory. Glory Ltd has increased it’s selling price by 3% since the last month.
Required:
What will be the relevant cost of materials for the project.Well, the 5000kg is in inventory and has not been used, so we only need 3000 kg to complete the order so the relevant cost is 3000*4.12 = £12360 but this answer is wrong! Why? The correct answer is (8000*4.12) = £32960 but why should we take 8000 in the first place? We already 5000 materials purchased in inventory, so to complete the order we just need 3000 more to finish the order, so we take 3000. Why take the whole of 8000? Is that breaking the rule that the cost of purchased inventories is a sunk cost?
Please explain. Thanks.
The cost of purchased materials is indeed a sunk cost.
However since Wonder uses cotton in regular production, if we take some from the existing inventory then it means they will have to buy more than they would have for their normal production. (They were expecting to use the existing 5000 in normal production – if we take it for the contract then they have to buy more than they were expecting to.)
If material is used in regular production then always the relevant cost is the current purchased price.
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